Focus on the Quality of Earnings

First-quarter 2013 earnings season kicks in this week, and for the next several weeks the markets will have a lot of raw data to digest and interpret.

I suppose that as long as the Federal Reserve is out buying securities, earnings may not matter as much. Last week's lower-than-expected jobs report didn't send the market into a tailspin, precisely because the weaker jobs number suggested that the Fed wouldn't consider pulling out anytime soon. Mr. Market likes the Fed.

In the short run, the market is a voting machine that reacts to the daily mood of investors. In the long run, however, the market is a weighing machine that reacts to the fundamental growth and cash that a business generates. So when going over earnings reports this month, do not focus only on the headline number or merely the growth in EPS. Instead, focus on the quality of the earnings.

As you examine an earnings report, here are some guideposts to help you assess the overall quality of a company's reported earnings.

Let's start with the income statement. You can start from the bottom and work your way up. If a company reported increased profits, see if one-time adjustments had anything to do with that increase. Were tax rates lower this quarter? Did the company sell an asset at a gain? Were selling, general and administrative expenses lower?

Alone, items such as this may indicate that the operating results were not as good as stated. What you want to see are positive trends at the top of the income statement. Are sales increasing, and are gross margins improving? If gross margins are improving, that could suggest that the company is getting better terms from its suppliers, which indicates a position of strength.

Moving on to the balance sheet also helps qualify the income statement. If a company's sales are growing but receivables are growing just as fast or perhaps faster, make a note to keep tabs on that. A retailer is a great example. By extending generous credit terms, a retailer can increase sales and reported profits. But if the receivables are getting paid, the sales growth doesn't mean much.

How can you cross-check that? Go straight to the cash flow statement and compare cash flow from operations with reported net income. A surge in receivables negatively affects cash flow and will show up.

If a company sells products, pay attention to its inventory. Earlier I said that an increase in gross margin can be a good thing, as it suggests lower prices from suppliers. These lower prices can also come from a company buying in bulk, and that is not a bad thing if the products can be sold at attractive prices. The key here is to consider the product and whether it can become obsolete quickly (electronics, apparel, perishables) or whether it has an indefinite shelf life (jewelry, hammers).

Moving on down, you want to certainly pay attention to the liabilities, namely payables and debt, and see whether the trend is negative or positive.

Always take a quick look at share count. Nothing is more disastrous to an investor than to have a company that is operating well dilute that performance by expanding the share count. If profits increase by 10% but the share count has appreciated by 10%, then earnings per share remain unchanged. Conversely, a reduction in share count can be the greatest creator of value. Just look at AutoZone's (AZO) performance over the past three, five and 10 years.

You must of course keep in mind that an earnings report is a snapshot of three months of performance, hardly a metric of completely assessing the quality of a company. One can of course go back and examine several quarters of data to get a more meaningful understanding of where things are headed. A pattern of behavior is much more telling than a single isolated event. A headline or a press release is hardly telling of performance.

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